Exploit This Volatility Spike With Iron Condors

by Tyler Craig | April 16, 2013 9:13 am

After a day where gold and silver stole the headlines, you might think all the noteworthy movement was limited to the commodity space.

Well, think again.

Small-cap stocks appear to be following the twin precious metals into the abyss. While the iShares Russell 2000 Index Fund (NYSE:IWM[1]) didn’t fall to the extent of silver (thank goodness!), it did lose almost 4% Monday — quite the one-day haircut. In fact, it’s the largest one-day drop in IWM since October 2011.

Click to Enlarge The 3.77% drubbing adds to an ever-increasing list of deterioration signs in the land of small caps. While the little guys led the bull market rally off the November 2012 lows, they began changing their stripes in mid-March from market leaders to market laggards (see bottom panel in accompanying chart). Monday’s downdraft only worsens the relative weakness.

With the formation of last Thursday’s lower pivot high, the trend of IWM is showing definitive signs of an intermediate top. It’s also firmly below its 50-day moving average and has a 20-day moving average that is now declining.

Click to Enlarge Amid yesterday’s small-cap swoon, implied volatility, as measured by the CBOE Volatility Index (CBOE:VIX[2]), was up over 43% to 17.27. Though the volatility spike was only the fifth largest since 1990, it was historic by at least one measure. According to fellow Chartered Market Technician Ryan Detrick[3] of Schaeffer’s Investment Research, the 43% increase was the largest VIX move ever during a 2%-to-2.5% drop in the S&P 500.

The IV lift should be viewed as a welcome development for option sellers going forward, as it allows the ability to sell options for higher premiums. While the VIX might climb further in the coming days, it’s at least risen to high enough levels to consider scaling into new short option positions.

Here’s one idea worth considering if you believe the Russell 2000 Index is more likely to trade in a range over the coming month as opposed to completely cratering:

Sell the June 800-810-980-990 iron condor for around $2.00 credit.

The four-legged neutral spread consists of simultaneously selling the June 800-810 bull put spread and the 980-990 bear call spread. Consider it a bet that the Russell remains between 810 and 980 — a $170 range — by June expiration.

Selling a put spread at $810 allows plenty of room to the downside in case the current correction persists for longer than expected. Additionally, with the long-term trend of the Russell still rising and with Uncle Ben still fully engaged in quantitative easing, you could make the case that the current pullback won’t be too severe.

The max reward is limited to the initial $200 credit and will be captured if the index remains within the aforementioned range. The max risk is limited to the distance between strikes minus the net credit, or $800.

As of this writing, Tyler Craig owned neutral positions on the Russell 2000 Index.